ASX Options Monthly - December 2014

The Exchange Traded Options market is reliant on market makers to help facilitate liquidity and trading. In turn, market makers are reliant on providing pricing and liquidity opportunities for the market to enable them to increase their business.

When trading, one needs to be mindful of the market conditions and dynamics to ensure trading occurs at the best possible prices. There are some basic rules that should be followed to ensure access to the best possible prices in the market. The following is a summary of things to consider doing and a few things to avoid.

Dos:

1. For best liquidity and pricing, trade options with an expiry date less than 12 months and a strike price close to the current stock price.

2. Trade options on highly liquid stocks. The ASX provides options on the top 70 companies, and the liquidity of the top 20 stocks can be much higher than the following 50 companies.

3. Use combination orders where possible. Combinations will generally result in better prices as market makers will have lower hedging costs and their competitive pressure can result in better prices.

4. When selling or writing options, consider European-style options around dividend time and when there are corporate actions to avoid unwanted exercise. Be mindful that no market maker obligations exist on European options, meaning that in the absence of the anticipated corporate action, you are likely to get better prices on American-style options.

5. Target prices in the mid-point of the spread. Generally it is possible to get prices better than on screen as not all market maker liquidity is via continuous quoting.

Don’ts:

1. Trade at times when market makers are not available or reluctant to trade. Generally trading equity options in the first 20 minutes of trading, or after approximately 3.55pm Sydney/Melbourne time can have lower liquidity resulting in worse prices. It is best to avoid trading during these times, unless you have to.

2. Don’t leave your trading decisions to the last minute on options expiry day. Trading when you’re desperate will generally result in poorer price outcomes.

3. Trade immediately around corporate actions (if you can avoid it). Often the morning after a major corporate action like a profit downgrade the market will be extremely volatile as the market looks to find a base. Market makers are less confident of getting their hedges set in extremely volatile markets. This means they will quote wider spreads. As such if you are able to avoid trading at such times you may likely get a better price.

While applying such rules is not a ‘silver bullet’ to guarantee improved pricing, following the above will generally help you to get the best possible prices through your broker.

The delta on an option is a member of a Greek family of risk sensitivity indicators that determines the price of an option. More importantly, the delta is the rate the option price will move, given the change of the underlying stock/index.

What does this mean for today’s topic, ‘price discovery’?

Well if we can predict how the price of an option will move in relation to the stock/index, we can have a healthy expectation on how and when our orders will be filled in the market.

The Delta is represented in mathematical terms between 0-1. Options that are in the money have a delta of 1, options that are well out of the money have a lesser rating of say 0.1. As the options moves closer to being in the money, the delta will increase.

So what does this mean? An option with a rating of 1 will move cent for cent to the underlying stock/Index. If the stock moves 1 cent, then so does the option.

If the option has a delta of 0.5 and the underlying moves a cent, the option will move ½ a cent.

If the option has a delta of 0.1 and the underlying moves a cent, the option will move 1/10 of a cent.

One important point needs to be made: as calls and puts are polar opposites this is reflected in the delta as well. Calls have positive deltas and puts have negative deltas. For example if the underlying rises the value of the call will increase, the put will decrease.

So as you can see from the above examples, delta can create more certainty. For further details please contact your broker.

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b) Sell 20 BHP January 2015 $34.01 Call Options (European style) @ $1.00/ $2,000
For the sake of the example we will estimate the brokerage and ASX charges as $300 incl. GST.
The investor would receive $1,700 in net option premium. This therefore reduces the investor’s buy price down from $33.25 to $32.40 per share. (85c per share or 2.55%)

As the heading says, you can potentially write calls on your stock till the cows come home, providing you are squeezing out most of the ‘option premium’ on each series and that you are not allowing yourself to be exercised.

What are the various scenarios?

1. BHP falls in value

Roll the position before expiry: If the share price falls to $32.00 then the Call option premium reduces in value. Many times I have bought back a ‘sold call option’ to take the profit before it expires and then sell another option for more money out to a further expiry date and sometimes a different strike price.

Example: Buy back the 20 BHP Jan 2015 $34.01 (European) Calls for 20c (was sold for $1.00) and pocketing the difference. For argument sake say the profit becomes $1,200 after brokerage and ASX charges and then go and sell 20 BHP March 2015 $33.01 Calls @ $1.00 / $2,000.

With this series, the strike price is 24c below the investor’s initial stock buy price (buy price was $33.25), but since then the investor has received an equivalent of 60c per share profit (the $1,200) from taking the profit on the last sold Call option and now bringing in another $1.00 per contract in option premium or $2,000 in total premium. Again, after brokerage and ASX charges, this option premium is more like $1,900 (or 0.95c per share). Add the 60c (the crystallised profit) then becomes $1.55.

With the 20 BHP March 2015 $33.01 Calls, if on expiry the stock closes above the strike price and the investor chooses to be exercised @ $33.01, then the investor must subtract 24c from the $1.55. The result would then become $1.31 per share or $2,620 of maximum option premium to be earned from the two above scenarios. The investor's buy price on BHP shares now becomes $31.94 (down from the initial buy price of $33.25).

Roll the position after expiry: If the share price falls to $32.00 and the options expire worthless, meaning that the investor will retain their shares but also pocket $1,700 of option premium (or 85c per share). You’ve reduced the buy price on your stock from $33.25 down to $32.40.

Now as one knows, share prices fluctuate and you can either wait for the share price to run higher before repeating this exercise and sell the same Call option with the same strike price but with a different expiry, or immediately sell a further dated option contract and/or at a reduced strike price but without jeopardising your purchase price.

If BHP were to remain at the same value, again the options will expire worthless, meaning that the investor can retain their shares but also pocket $1,700 of option premium (or 85c per share).
You’ve reduced your buy price on your stock from $33.25 down to $32.40. You can now repeat the same exercise but with a different expiry. Sell 20 BHP March 2015 $34.01 Calls @ $1.15 / $2,300.

3. BHP rises over the strike price of the call option

If the share price is over $34.01, the investor can either let the option be exercised, therefore selling their shares at $34.01 (irrespective of the prevailing share price at the time). They can also buy back the position and sell a new position potentially allowing them to retain their stock.

Conclusion
These strategies not only reduce your entry price into a share investment, but also reduces your portfolio’s downside risk. Imagine being able to do this a few times per year and how far down it would take your purchase price.

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